Friday, July 12, 2013

Most of the commentary one reads these days about the negative consequences of the policies set by central banks (low-interest rate and quantitative easing) are not backed by any economic model that I know. The criticisms make constant reference to "distorted" interest rates, "artificially low" cost of capital, mispricing of bonds and other assets as channels through which the misguided policies of central banks are causing low growth, uncertainty and volatility. But what is the economic model that can provide a theoretical justification to an environment where the central bank can significantly affect equilibrium asset prices and interest rates for a prolonged period of time and without causing inflation? I have not seen it yet.

When we teach the effects of monetary policy we tend to use economic models that have a Keynesian flavor to it, with some form of price rigidity and where changes in the nominal interest rate by central banks have a short-run impact on real interest rates (as inflation moves slowly). But this only works in the short run, while prices are rigid. Once price flexibility kicks in there is no way for the central bank to have an influence on relative prices (of assets or goods and services).

But what I find most puzzling is that those who talk about distorted and manipulated interest rates are the ones who tend to criticize the predictions of Keynesian models in the first place! They are the ones who tend to use as a justification for their arguments models where central banks have no impact on the economy even in the short run. How is it that now suddenly central banks have become so powerful that they can determine "real" (relative) prices for an extended period of time? I need to see the model.

Antonio Fatas

I am the Portuguese Council Chaired Professor of European Studies and Professor of Economics at INSEAD, a business school with campuses in Singapore and Fontainebleau (France), a Senior Policy Scholar at the Center for Business and Public Policy at the McDonough School of Business (Georgetown University, USA) and a Research Fellow at the Center for Economic Policy Research (London, UK).